William G. Gale is senior fellow at the Brookings Institution and author of Fiscal Therapy: Curing America’s Debt Addiction and Investing in the Future (Oxford 2019). The opinions expressed in this commentary are his own.
Congressional Budget Office projections released earlier this month show that the United States faces an unusual combination of rising federal debt and low interest rates.
Rising debt will make it harder to maintain economic growth, boost living standards, respond to wars or recessions, address social needs and maintain our role as a global leader. Lower interest rates make debt accumulation less costly. At the very least, low interest rates undermine claims that current debt levels will cause a financial crisis. But low interest rates aren’t a cure-all for the budget. They don’t necessarily make the US government’s long-term fiscal position sustainable, a point explicitly recognized even by those economists who argue most forcefully that low interest rates should guide short-term policy.Despite low interest rates, the fiscal outlook is generally worrisome. In the past, the deficit spiked only on a temporary basis — during recessions. Now, although the economy has grown for 10 years in a row and is near full employment, the deficit is high and, without any policy changes, will remain elevated. It will rise further if policymakers continue to extend temporary tax and spending provisions. Over the longer term, rising payments for Social Security, Medicare, Medicaid and interest on debt will make government spending grow much faster than revenue, adding even further to our deficits. Read MoreLow interest rates generally help the government because it borrows more than it lends. But there are two caveats. First, we can certainly borrow more and consume more with low interest rates and not hurt future generations (who can in turn borrow more from later generations). But this pattern is only optimal if interest rates don’t rise to high levels again. If we borrow more and interest rates subsequently increase, we will face higher charges on higher levels of debt. Second, in the past, policymakers have chosen to pre-fund — or set aside money for — Social Security and Medicare obligations in order to improve the fairness and stability of funding for those programs. With lower interest rates, however, any level of pre-funding will require higher taxes (so policymakers can set aside more money for pre-funding) or lower spending (reducing the need to pre-fund), either of which would make program financing and benefits more vulnerable to recessions.How should policymakers respond? They should not try to reduce this year’s deficit. That’s not the problem — the long-term pattern of debt accumulation is. Cutting current deficits would likely reduce aggregate spending, a change that the monetary policy authorities may have difficulty offsetting precisely because interest rates are so low.Instead, policymakers should enact new investment programs in infrastructure, research and development and human capital, even though it might increase the deficit. These programs would help maintain growth and expand opportunity in the United States. Funding these projects with taxes would generate better fiscal and economic growth. But policymakers should choose deficit-financed investments when the alternative is no investment. More Markets & Economy Perspectives
Policymakers should also enact a plan implemented on a gradual, phased-in basis that will substantially reduce long-term deficits and debt. This approach would not significantly reduce current aggregate spending. In fact, policies like phased-in consumption taxes or carbon taxes would give people and firms incentives to boost current spending and production before taxes increase. Restoring Social Security to long-term solvency and shoring up Medicare by increasing competition in health insurance markets and reducing medical costs are also a part of this long-term solution. Gradual changes like these would stabilize the debt at reasonable levels and help the economy grow in the long term, reducing burdens on members of future generations, many of whom will not be better off than their parents. Reducing the long-term deficit would provide some fiscal insurance against interest rate jumps and other adverse fiscal outcomes. With already high debt projected to rise even further, the budget is more sensitive to interest rate fluctuations now than it has been in the past. A gradual phase-in of deficit reduction policies would also provide time for businesses, investors and citizens to adjust their economic plans and would reduce political backlash. Finally, a gradual debt reduction plan would give economic agents more certainty about future policy and offer policymakers assurance that they could undertake new initiatives within a framework of sustainable fiscal policy.